Often, people take too much risk believing the myth that equity is safe in the long term
Almost everyone believes that equity is safe in the long term. For example, almost everyone believes that if you will retire more than five to 10 years later, then it is safe to invest most of your net worth in equity. The data, theory and principles of finance all disagree with this myth. And, sometime over the next decade or so, believing in this myth may have devastating consequences. “Equity is safe in the long term" is a vague statement that we cannot test. A more precise version of this statement is something like, “if you hold equity for five to 10 years, then you can be sure that it will at least match inflation (i.e. roughly match the returns of a zero-risk debt liquid mutual fund) and, on average, it will generate higher returns than inflation".
The theory and principles of finance (the principle of “no free lunch") are complex, so let’s focus on the data instead.
Within India, more than 10 years after the market peak of 8 January 2008, the NSE Nifty 50 Total Return Index (TRI; including dividends) is yet to catch up with (but it is close to catching up with) cumulative inflation. However, Indian data has a very short history which makes it less useful for such analysis. Price indices (excluding dividends) are available for only a little more than three decades. And total return indices, which are more relevant, are available for only a little more than two decades. That forces us to look at international data.
The best data that is available is for the US, but the US has been one of the best performing stock markets in the world over the last 118 years. So focusing only on US data leads to significant biases in the conclusions. Instead, one should look at data from as many countries as possible. Three professors at London Business School did exactly that. They studied several countries, typically from the year 1900. The relevant data from their study is in the summary version of the Credit Suisse Global Investment Returns Yearbook 2018.
Nominal returns are returns that we talk about in daily life. For example, the interest rate on a fixed deposit. And nominal returns minus inflation is called real returns. So, the longest runs of cumulative negative real returns for equity, as shown in the report, was 16 years in the US, 22 years in the UK, 54 years in France, 55 years in Germany, 51 years in Japan, 22 years for the world and 27 years for the world excluding the US. In simpler terms, there was one period of 54 years during which cumulative equity returns in France did not even match inflation. This list includes one example (France) that ends in 1982. But there are a few recent examples as well.
In the US, the S&P 1500 TRI fell in early 1973 (around the first oil crisis) and caught up with cumulative inflation only 12 years later, in early 1985. Similarly, the S&P 1500 TRI fell in mid-2000 (around the dot-com crash) and caught up with cumulative inflation only 13 years later, in mid-2013.
The Japanese Nikkei 225 Price Index (i.e. excluding dividends) reached an intra-day peak of 38,957 in late 1989. Today (29.5 years later), it is around 21,124 i.e. 45% lower. Even after factoring in dividends, the Japanese stock market’s cumulative returns are lower than the cumulative inflation over the last 29.5 years.
Believing the myth that equity is safe in the long term is one of the key reasons that people take too much equity risk. The reality is that over a 5-10-year horizon, there is a higher probability that equity will at least match inflation but there is also a material probability that it will generate returns that are lower than inflation. I have discussed one implication of this in a previous article.
Inflation indexed bonds (or inflation-protected bonds) largely do not exist in India. So Indian residents are almost forced to invest in equity and real estate (i.e. risky investments) to protect against the rare risk of very high inflation. But too high an allocation to risky investments could lead to permanently losing half of that investment (in real value of money). So, one must find some middle ground and lean towards taking less risk. The recent high returns from equity has led many people to do the opposite.
Avinash Luthria is a Sebi-registered investment adviser and founder of Fiduciaries.in